Question Nathan Finance & Economics

Distinguish between classical, neo-classical and keynesian economics

Distinguish between classical, neo-classical and keynesian economics?

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Classical economics is attributed to economists such as Adam Smith and David Ricardo who were mainly concerned with how economies grew and prospered. Classical economics paved the way for Neoclassical economists who tend nowadays to be described as the mainstream economics. For much of the post WW2 era, the mainstream also included Keynesian economics.

The classical model of economics was popular before the Great Depression. Classical economics believes that the economy is self-correcting. According to Say’s law, supply creates its own demand. Excess income (savings) should be matched by an equal amount of investment by business. Interest rates, wages and prices should be flexible. Classical economists believe that the market is always clear because price would adjust through the interactions of supply and demand. Since the market is self-regulating, there is no need to intervene. Economists who advocate this approach to macroeconomic policy are said to advocate a laissez-faire approach. The market will reach full employment by itself.

Neo-classical economics paradigm assumes that economic actors are rational; have good information and are trying to maximise utility subject to a budget/income constraint (it focuses on microeconomics). Such economics stresses the price mechanism and the use of supply and demand.

Keynes argument was that Say’s law does not hold. The 1930s Great Depression seemed to refute the classical idea that markets were self-correcting and should provide full employment. Keynes provided some explanations: 1) savings and investments are not always equal; 2) producers may lower output instead of prices to reduce inventories; 3) Lower production may increase unemployment rate and decrease incomes; 4) monopoly power on the part of producers and labour unions would prevent prices and wages to adjust downward freely. According to Keynes’ theory, wages and prices are not flexible. Rigid price will give a horizontal AS curve in the short run.